 and welcome to the session. This is Professor Farhad and this session we're going to be looking at the US treatment of foreign operation income. This topic is covered in international accounting or taxation course covered on the CPA exam as well as the ACCA exam. As always, I would like to remind you to connect with me only then if you haven't done so. YouTube is where I house all my 1500 plus accounting, auditing, tax and finance lectures and this is a list of all the courses that I cover. Also on my website you have access to additional information and material such as the PowerPoint slides, true, false, multiple choice exercises and 2000 plus CPA questions if you are preparing for your CPA please check it out. Studypal.co is an artificial intelligence driven study body system that matches you with a CPA, CFA or any other exam you are studying for. I suggest you check it out. They're available in 85 countries and 2500 cities. So this session is pretty comprehensive. What do I mean? It's pretty comprehensive. Everything that you have learned up to this point about tax jurisdiction, foreign control corporation, tax haven, sub chapter F income and tax credit, we're going to be applying and a comprehensive example. So what I suggest you do if you have any doubts about any of these terms, please look for the link in the description below. I have the playlist. You could look at them before we start to work this example because this is going to bring everything together. So how do we determine whether an income is included? The foreign income is included in US taxable income. Well, there are a few factors we have to take into account. We have to take into account the legal form of the foreign business. Is it a branch or is it a corporation or a subsidiary? What I mean corporation is a subsidiary. What about the who controls the corporation? Is it is it a controlled foreign corporation or it's not a controlled foreign corporation? And that's why if you don't know what controlled foreign corporation is or if you don't know what tax jurisdiction is, you won't be able to know the difference between branch and corporation and CFC or not. Also the effective tax rate, whether we are operating in a tax haven territory or not the tax haven territory and the nature of the foreign source income, whether it's a chapter F income or not. And we need to learn about, well, we need to apply at that point, the appropriate foreign tax credit basket, which we also covered this. So everything that that's in here, all the factors I already explained. So what I'm going to take all these factors and work an example or summarize them into an example and see how this whole picture fits together. So that's why you want to know everything before you start this session. Okay, so let's go through the let's go through this chart and see how it works. First we ask ourselves, is this a branch? So is the foreign operation a branch? Well, if the answer is yes, it's a branch. It's not a subsidiary, easy. We're going to take the income from that branch and treat it as if it's in the US. So the foreign income included a new taxable income. That's easy. So if we are operating, not as a branch, not as a branch means as a subsidiary. Well, then we have to ask ourselves, is that subsidiary a controlled foreign corporation? Well, if the answer is no, well, if the answer is no, the US don't own the US shareholders don't own more than 50%. And remember, we only count the US shareholders that have 10% or more, then we don't have to worry about this, then it's not taxable in the US. So that's easy decision to it's a core and it's not a it's not a controlled foreign corporation. Therefore, it has nothing to do with the US in a sense. Therefore, the taxable income is not included. If it was a controlled foreign corporation, then we have to ask ourselves, what is the effective tax rate? Simply put, remember the corporate tax rate we are using in the US is 21%. Okay. And remember, there is a there's basically a safe harbor rule, which is 90% of this 18.9. If the corporation it's controlled foreign corporation, but they're paying more than 18.9, which is more than 90% of the tax of the US tax rate, then good for them, then it doesn't matter foreign income is not taxable in the US because they're paying enough taxes. So although it's a foreign control corporation, but they're paying more than 18.9, which is 90% of 21, then that's fine. If they are, if the effective rate is less than 18.9, and it's a controlled foreign corporation, then we have to determine whether they have sub chapter F income. So whether sub chapter F income also specifically represent more than 5% of their total income. If it's not more than 5%, that's fine. We don't have to worry about them. So here we go. So we have to worry about them if they are controlled foreign corporation, then they are, this is a tax haven. They are operating in a tax haven. And the sub chapter F income is more than 5%. Because if it's less, that's, that's fine. US doesn't worry about this. Now, if the sub chapter F income is between 5% and 70% of the total income, then we will tax them based on the proportionate income of the sub chapter F income. So if they earn 30% of their income sub chapter F, we include 30% of the income in the US. And by the way, I went over this in another session. If more than 70% of their income is considered sub chapter F income, again, if you don't know what sub chapter F income go to that, go to that recording, then everything is included. Everything is included. Then after we determine whether, you know, they are taxable or not, we have to allocate each foreign entity US taxable income to the appropriate foreign tax credit basket. And we talked about this in the prior session, the foreign tax credit basket. We have three baskets, general income, passive income and branch income. Then we have to determine the tax liability before the tax credit, foreign tax credit and the net US tax liability after the foreign tax credit basket, which we'll see this in a moment. Then we have to determine the US tax liability. So those steps we're going to look, we're going to see when we work the example next. But this is what we have to do. Okay, this is what we have to do. And the best way to illustrate this concept, I mean, I would suggest you take notes from this slide or if you want to go to my website and subscribe, you can download it. But this is, this is what we're going to be using. So to illustrate this concept, we're going to assume a US multinational that has operation in Costa Rica, Zimbabwe, Uzbekistan and the Cayman Island. Okay, in four different places. And I'm going to show you the data for all, for everything. And we're going to go through those steps, step by step to determine how much of the income of from these corporations or subsidiaries or branches is included or not included. Let's first take a look at our Costa Rican operation. It's a branch. The US multinational own 100%. It's manufacturing. Before tax income is 100,000 income tax is 30%. After tax income is 70,000. This is 100 is the pre tax income. Grows, they didn't pay any dividend with holding grade. There's no withholding grade, net dividend receive, they didn't receive any dividend. Okay, so this is the Costa Rican. Now remember, the Costa Rican is, look, if this is, this is easy answer, I'm just gonna, I'm gonna give you the Costa Rican is a branch. Sorry, it's a branch because it's a branch. The income is going to be included in the US period, right? Because it's a branch. Okay, that's easy. That's an easy answer here. We don't have to go any further. Remember, the first thing is that a branch or a subsidiary, it's a branch. The Zimbabwe incorporation. It's a corporation. It's not a branch. It's a subsidiary. The multinational owns 50%, I'm sorry, 80%, which is, it makes it a foreign, a foreign controlled corporation. They're undermining business. Their pre tax income is 100,000. Their tax rate is 25%. Their after tax income is only 75,000 after they paid the taxes. They paid dividend to the multi to the US company of 20,000. The withholding grade is 10%. Net dividend received by the multinational is 18,000 because again, there's a 10% withholding, right? 10% of 20,000 is 2,000. The dividend received by the US company is 18. The Uzbekistan is also a corporation. The multinational owns 100% there in sales. I'm going to tell you a little bit more about the Uzbekistani operation. 15% of their sales is local and 85% to other countries. Their income before taxes also 100,000. The income tax rate is 7.5. Income after tax is 92,000. They paid everything to the main company, to the US company. The Uzbekistani is what held 10%. Therefore, the net dividend received is 83,250. They came in Ireland, 100% owned by the US. It's investment. The only activity is investment, which is a passive income. Pre-tax income is 100,000. They paid no taxes. Their after tax income is 100,000. They paid no dividend and there is no dividend withholding grade. So this is the fact. Now, again, you want to take a picture of this. You want to whatever you want to do because the next thing we're going to determine how much of the income of these subsidiaries or branches is included in the US. Actually, we already figured out the branch is easy. The branch is 100%. So the first thing we have to determine kind of the first test, is it a branch or is it a subsidiary? Well, we're ready to determine the Costa Rican operation is a branch. So that's done. That's an easy answer. So what's going to happen is this $100,000, it's going to be included in the US. In the US, taxable income. That's easy. The other three are subsidiaries. The other three are subsidiaries. Now, the next thing, once we determine they are subsidiaries, we have to check whether they are controlled for incorporation. If they are controlled for incorporation, the next thing we have to check is the sub-chapter of income. Well, all three are owned more than 50% by the multinational. It means all three are controlled for incorporation. All three are controlled for incorporation. The next thing we want to see if they are operating in a tax haven country. Why? Because if they are not operating in a tax haven country, well, guess what? They're paying enough taxes. We don't have to make them pay taxes in the US. Are they operating in a tax haven country? Now, we have to figure out the effective tax rate. As long as the effective tax rate where they're operating is less than 90% of the US tax rate. The US tax rate right now is 21%. Therefore, as long as they are paying more than 18.9%, we don't have to worry about them. So therefore, we stop. Their income is not included. But if they're paying less than 18.9%, we have to include their income. So to compute the effective tax rate, we have to include the withholding rate with that. So let's take a look at them. Starting with the Cayman Island. The Cayman Island, the rate is zero. Guess what? Cayman Island is a tax haven. So that's easy. Why? Because the income tax rate, so basically you start here. The income tax rate is zero and there is no withholding tax rate. So that was an easy answer. So the Cayman Island is a tax haven is Pakistan. The income tax is 7.5. Then you have to add the dividend, the withholding rate. The withholding rate is 10%. But remember, you have to deduct 0.25 from the withholding rate. Now, why do you have to deduct 0.25? Because after they pay you, after they send you the money, they have to help 0.25. Why 0.25? 10% times 0.75, because they already paid 0.75 under taxes. Therefore, it's 7.5 plus 10% times 0.25, 0.25, which will give you in total 16.75. 16.75 is less than the safe harbor rate, 18.9. Therefore, the Uzbekistan is also a tax haven. So Uzbekistan is a tax haven. The Cayman Island is a tax haven. Now, we want to see the sub-chapter F income, but we're going to find out shortly. The Zimbabwean is their income tax, their income tax rate is 25%. We can stop right here. It's not a tax haven. But remember, you have to add to it the withholding rate times 1 minus the withholding rate, which is 75%, which is 1 minus 0.25 is 0.75, which is 0.75 of 10% is 0.75. So 25 plus 0.75, the effective tax rate is 32.5. Well, 32.5 is greater than 19%. Therefore, the Zimbabwean, we don't basically, we don't have to go any further, because they're paying enough taxes. So what we're left with is the Uzbekistani operation, and the Cayman Island. Now, since they are in a tax haven, they are controlled foreign corporation and they operate in tax haven. Now, we have to look to see if they have a sub-chapter F income. I told you about the Zimbabwean operation. It's not a tax haven. So we're done with that. The Cayman Island, they have a passive income. Passive income is sub-chapter F income. Therefore, guess what? The Cayman Island income, that 100,000 will be included in the U.S. with the U.S. taxable income. The Uzbekistan, they import finished goods, then they sell in the region. And I told you 15% local, 85% to outsider. This is considered a foreign-based company sales income. This is sub-chapter F income. And if you don't know what this is, please go to my controlled foreign corporation sub-chapter F income that they do qualify for sub-chapter F income. So simply put, here's what's going to happen. We're going to include 100% of the Uzbekistani income. We're going to include 100% of the Cayman Island. And obviously, the Costa Rican branch will be included. The Zimbabwean, they're paying enough taxes. We don't have to worry about that. So let's take a look at this. Again, this is the branch for the Costa Rican operation. The U.S. taxable income is 100,000. If they were in the U.S., they would pay 21%, which is 21,000. They actually paid to the Costa Rican government $30,000. Well, guess what? Since they paid $30,000, we can only give them a foreign tax credit of 21%. We're not going to give them tax credit for more than what they would have paid in the U.S. Therefore, the U.S. tax liability is zero, because the foreign tax credit will eliminate this 21,000. The U.S. tax liability is zero. It's not only zero. Now, they carry an excess foreign tax credit for the future, or they can go back if they want to, of $9,000. Now, let's take a look at the Uzbekistani operation, which is the general income. Notice we have to break them down into baskets. The branch is different than the subsidiary. And within the subsidiary, we have a general income, and we have passive income from the Cayman Island. So this is the, so the passive income is from the Cayman, and this is from the Uzbekistani. Okay? So again, we'll take 100,000. In the U.S., they're supposed to pay 21%, which is 21,000. Well, they only paid to the foreign government $16,750. Well, the overall foreign tax credit is 21,000. They didn't even pay that much. So we have to choose between 16,750 and 21,000. The lower the lower is 16,000. So they're supposed to pay 21, they only paid 16,750. It means they have to write a check to Uncle Sam for $42,50. Okay? And they obviously don't have access foreign tax credit. Also, the Costa Rican branch cannot help them because they're in a different basket. So we cannot use the excess foreign tax credit from the Costa Rican branch to reduce the tax bill for the Uzbekistani operation. Okay? Let's see the Cayman Island. The Cayman Island, the 100,000 is included. They have to pay 21,000. They paid zero, and they have to pay 21,000. The max credit is 21. We have to choose between zero and 21. They only paid zero. So they paid nothing. Therefore, they're responsible for writing a check to Uncle Sam, $21,000 because they have to pay taxes on that money. It is controlled for incorporation in the tax haven and subchapter F income. Okay? So what's their access foreign tax credit? Nothing because they have to write a check. Once again, the Costa Rican branch cannot save them. Cannot save them because it's in a different basket. So overall, what's going to happen is the multinational corporation will pay in taxes 25,250. They will have access foreign tax credit for the Costa Rican branch of 9,000, which can be used later on when the rate in Costa Rica is lower than the U.S. rate. But just one, you know, prior to 2018, the Zimbabwean dividend would have been included in the U.S. taxable income. Remember, the Zimbabwean send dividend to the U.S. It would have been included under the new tax law, which is the participation exemption approach to tax and foreign income. That's not the case anymore. So the Zimbabwean, as we said, we don't have to worry about this. Even the dividend that they send us, we don't have to worry about that. In the next session, hopefully, I hope this example gave you an overview about all the rules, because this is a good example. Just shows you everything from A to Z. In the next session, we would look at the U.S. tax reform 2017 and other international tax provision. If you have any questions, please email me. I strongly suggest you go to my website, visit my website, consider subscribing. It's an investment in your career. You have access to many resources that's going to help you understand and expand your knowledge about this topic. Good luck and study hard.